Behavioral Finance

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Lecture 14

• Behavioral Finance

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• The primary source of this lecture is from the
  book by
• Hersh Shefrin, Beyond Greed and Fear
  Understanding Behavioral Finance and the
  Psychology of Investing, Harvard Business School
  Press, 2000.

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Behavioral Finance

• Financial practitioners commit errors because
• 1. They use rules of thumb or
  heuristics.
• 2. They are influenced by form as well as
  substance.
• These errors cause market prices to deviate from
  fundamental values.

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Heuristic-Driven Bias

• Heuristic refers to the process by which people
  find things out for themselves, usually by trial
  and error.
• Trial and error leads people to develop rules of
  thumb which often causes errors.

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Heuristic-Driven Bias

• Representativeness
• gt Refers to judgments based on stereotypes.
• gt People believe that a small sample is
  representative of the entire population.

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Heuristic-Driven Bias

• Gamblers fallacy
• gt In a coin toss, what is the probability
  of a tail after five straight heads?
• gt The law of large numbers. If x is a
  random variable with Exm, then the sample
  mean of x approaches m as the sample size
  increases.

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Heuristic-Driven Bias

• Overconfidence
• gt People set overly narrow confidence
  intervals.
• gt They get surprised more frequently than
  they anticipate.

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Heuristic-Driven Bias

• Anchoring-and-Adjustment
• gt People do not adjust their expectations
  sufficiently in response to new
  information.
• gt They are anchored to their initial
  expectations.

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Predictions

• DeBondts study Betting on Trends.
• People tend to naively project trends that they
  perceive in the charts.
• They are overconfident about their ability to
  predict accurately.
• Their confidence intervals are skewed.

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Heuristic Diversity

• Those that bet on trends extrapolate.
• Those who commit gamblers fallacy predict
  reversal.
• Both predictions stem from representativeness.
• They differ because of different perspectives.

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Heuristic-Driven Bias

• Confirmation biasthe illusion of validity.
• gt Most people have difficulty assessing the
  validity of statements like if X, then Y.
• gt They look for confirming evidence (X and Y
  hold) instead of disconfirming evidence
  (where X and not-Y hold.)

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Bullish Sentiment Index

• The Bullish Sentiment Index measures the percent
  of newsletter writers that are bullish.
• The indicator is viewed as a contrarian
  indicator.
• Since most advisory services are trend
  followers, they are most bearish at market
  bottoms and least bearish at market tops.

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Heuristic-Driven Bias

• The fear of regret leads to loss aversion.
• Regret is more than the pain of a loss. It is
  the pain associated with feeling responsible for
  the loss.
• Hindsight biasevents are viewed as far more
  likely than they looked before the fact.

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Heuristic-Driven Bias

• Loss aversionregret makes losses very painful.
• Faced with a loss, which choice would you make.
• A. A sure loss of 7,500.
• B. A 25 chance of losing 0 and a 75
  chance of losing 10,000.

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Heuristic-Driven Bias

• My intention was to minimize my future regret.
  So I split my contribution fifty-fifty between
  bonds and stocks. Harry Markowitz

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Heuristic-Driven Bias

• Aversion to ambiguityThere is a fear of the
  unknown.
• The bailout of Long-Term Capital Management.
• It was a very large unknown. It wasnt worth a
  jump into the abyss to find out how deep it
  was. Herbert Allison, Merrill Lynch President.

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Frame Dependency

• The form used to describe a decision problem is
  called its frame.
• Traditional finance assumes that frames are
  transparent.
• Non-transparent frames can affect decisions,
  thereby making behavior frame dependent.

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Frame Dependency

• First decision Choose
• A. A sure gain of 2,400, or
• B. A 25 chance to gain 10,000 and a 75
  chance to gain nothing.
• Second decision Choose
• C. A sure loss of 7,500, or
• D. A 75 chance to lose 10,000 and a 25
  chance to lose nothing.

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Frame Dependency

• People separate choices into mental accounts in
  order to help maintain self control.
• The dividend puzzle.
• For some investors dividends are a way to
  maintain self control.
• Dont dip into capital is a self control
  mechanism.

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Frame Dependency

• People split dividends and capital gains into
  separate mental accounts to protect funds
  designated for other goals.
• Selling assets to satisfy current consumption can
  cause regret if the security price increases
  after it is sold.

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Frame Dependence

• Money illusion.
• gt People naturally think in terms of nominal
  values.
• gt Emotional reaction is driven by nominal
  values even though people know the affect of
  inflation.

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Picking Stocks

• Investors are consistent in the mistakes that
  they make.
• They believe that
• 1. Growth stocks outperform value stocks.
• 2. Winners continue to be winners and
  losers continue to be losers.
• 3. Strong revenue growth will continue.

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Picking Stocks

• Analysts recommend stocks of past winners more
  often than stocks of past losers.
• Investors believe that good stocks and the stocks
  of good companies.
• The DeBondt and Thaler study.

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Picking Stocks

• It is difficult to arbitrage away these
  heuristic-driven biases.
• Some losers will continue to be losers.
• The strategy may not work in any given year.
• Hindsight bias will set in and the investor will
  feel like a fool.

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Picking Stocks

• Long Term Capital Management example.
• Royal Dutch Petroleum and Shell Transport and
  Trading jointly own Royal Dutch/Shell.
• All cash flow of Royal Dutch/Shell are divided on
  a 60/40 basis.
• The market value of Royal Dutch should be 1.5
  times that of Shell.

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Picking Stocks

• Shell Transport has traditionally traded at an
  18 discount relative to Royal Dutch.
• When the discount widened, LTCM bought Shell
  Transport and sold Royal Dutch short.
• Unfortunately, the discount widened.

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Analysts Earnings Predictions

• Positive (negative) earning surprises are
  followed by positive (negative) earning surprises
  for up to three quarters.
• Trading strategies based on post-earnings-announce
  ment drift generate abnormal returns.

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Analysts Earnings Predictions

• Analysts and investors remain overconfidently
  anchored to their prior view of the companys
  prospects.
• They underweight evidence that disconfirms their
  prior views and overweight confirming evidence.

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Analysts Earnings Predictions

• Analysts and investors place little weight on
  changes in earnings unless there is salient news
  associated with the announcement.
• They tend to overreact to salient information.

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Analysts Earnings Predictions

• Analysts long-term forecasts are overly
  optimistic.
• Analysts are highly dependent on executives of
  companies they follow for their information.
• Analysts are rewarded for bringing business to
  their company.

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Analysts Earnings Predictions

• Analysts short-term forecasts tend to be
  pessimistic.
• Companies try to encourage pessimism just prior
  to earning announcements.
• Stock prices jump when earnings beat the
  forecasts.

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Earnings Manipulation

• People have a tendency to evaluate outcomes
  relative to some benchmark.
• Three thresholds.
• 1. Zero earnings.
• 2. The previous periods earnings.
• 3. Analysts consensus forecast.

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Get-Evenitis

• Most people exhibit loss aversion.
• Consequently, they tend to hold their loses too
  long and sell their winners too early.
• Realizing a loss is painful, despite the possible
  tax advantage.

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Get-Evenitis

• Most people exhibit loss aversion.
• Consequently, they tend to hold their loses too
  long and sell their winners too early.
• Realizing a loss is painful, despite the possible
  tax advantage.

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Get-Evenitis

• Collapse of Barings Bank.
• Apple Computers Newton project.
• The definition of a good trader is a guy who
  takes loses. Alan Greenberg, Bear Stearns
  Company chairman

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Portfolio Decisions

• Investors decisions are driven by fear, hope and
  goal aspirations.
• Most investors think about portfolios in layers.
• gt Bottom layer for security.
• gt Middle layers for specific goals.
• gt Top layer earmarked for potential.
• Each layer is treated separately.

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Portfolio Decisions

• Investors are overconfident about their abilities
  to pick winners.
• They take bad bets because they fail to realize
  that they are at an informational disadvantage.

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Portfolio Decisions

• Investors trade more frequently than prudent
  because of over-confidence and a false sense of
  control.
• Individuals fail to diversify.
• gt The rule of five.
• gt Naive diversificationplace an equal
  amount across all funds available in their
  401(k) plan.

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Security Design

• Financial markets are beginning to provide
  securities that appeal to both hope and fear.
• British premium bondssafe principal plus lottery
  tickets in lieu of interest.
• Life USAs Annu-a-dexguaranteed 45 return over
  7 years plus 50 of the markets return over 45.

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Security Design

• Dean Witters Principle Guaranteed
  Portfolio50,000 investment in a zero-coupon
  bond with face value of 50,000 and risky stocks.
• A home made versionbuy money market funds and
  use the interest to purchase call options.

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Financial Advisors

• Having a financial advisor is like holding a
  psychological call option.
• Self-attribution biasthe investor attributes
  good outcomes to skill and bad outcomes to
  someone else or bad luck.